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01 06 2016 | by Victor Xing | Central Banks

December FOMC Minutes: policy reaction function in focus

Summary of the December 2015 FOMC Minutes

Minutes of the December 2015 FOMC provided additional context to the Committee’s decision to raise policy rates following seven years of zero lower-bound.  It did not offer new hints on the central bank’s rate path, but the extensive discussions highlighted senior Federal Reserve officials’ reaction function on inflation, labor market, financial conditions, foreign factors, and financial stability considerations.

By reiterating policymakers’ focus on energy prices (which is again making new lows) and dollar valuation (which has again risen), the latest Minutes helped shape investor expectations amid changing financial and economic conditions (thus, the expectation channel would act as an automatic stabilizer between financial markets and future policy decisions).  Indeed, investor expectations on number of rate hikes between now and Jan 2017 has fallen to less than 2 hikes at today’s session close vs. 2.4 hikes as of year-end 2015 (source: Bloomberg L.P. and author’s calculation):

Investors pared rate hike expectations as the latest FOMC Minutes was released
Market participants tapered rate hike expectations going into the December 2015 FOMC Minutes release on rising dis-inflationary concerns
It is worth mentioning FED Chair Yellen’s comments on inflation during the December FOMC press conference:

But we do need to monitor inflation very carefully because if energy prices and the dollar were to stabilize, import prices, our expectation is that both headline and core inflation would move up. And if we failed to see that occurring in the manner that we expect, of course we need to take further action to reconsider the outlook and to put in place appropriate policy.

Moreover, as dollar rises against a broad basket of currencies, the renminbi will face further depreciation pressure (if unchecked, the trading band will strengthen the yuan against currencies of other export economies)

FOMC Minutes highlighted on-going concerns on dollar valuation
The FOMC Minutes highlighted policymakers’ concerns on dollar valuation, as further dollar appreciation will increase likelihood of yuan depreciation and push down import prices (dis-inflationary)

Dec 2015 FOMC Minutes in detail

  • Policy normalization (rate hike)
    • Almost all participants agreed that the improvements that had occurred in the labor market and their confidence in a return of inflation to 2 percent over the medium term now satisfied the Committee’s criteria to begin policy normalization process
    • Participants saw several reasons why a gradual removal of policy accommodation would likely be appropriate
    • Participants emphasized the need to adjust the policy path as economic conditions evolved
      • Future policy path could become shallower if the economic expansion weakened and inflation rose more slowly than currently anticipated
      • Policy path would become steeper if real activity and inflation surprised to the upside
    • A number of participants pointed out that because inflation was still running well below objective, it would probably take some time for the data to confirm that inflation was on a trajectory to return to 2% over the medium term
  • Inflation
    • Nearly all FOMC participants continued to anticipate that inflation would rise to or very close to 2% over the medium term, as transitory effects of declines in energy and import prices dissipated and the labor market strengthened further
    • A majority of participants saw the risk to the outlook for inflation as balanced
    • Most participants anticipated that tightening resource utilization over the next year would contribute to higher inflation
    • Many participants lowered their near-term inflation forecasts while leaving medium-term outlook mostly unchanged
    • Many participants remained concerned about the downside risk of inflation
    • Many participants judged that falling energy prices would depress headline inflation somewhat longer than previously anticipated
    • Several participants observed that the additional appreciation of the dollar would continue to hold down the prices of imported goods
    • Several participants noted that alternative indicators of underlying inflation, such as the core CPI, the trimmed mean PCE, and the sticky price CPI, showed somewhat higher year-over-year increases, close to or above 2 percent
      • Participants recognized that these measures typically run higher than PCE price inflation
      • A range of views was expressed about these measures’ implications for the outlook for PCE inflation
  • Inflation expectations
    • Many participants concluded that longer-run inflation expectations remained reasonably stable
    • A number of participants noted that some of the survey-based measures could be overly sensitive to energy price fluctuations
    • Some participants expressed concerns that inflation expectations may have already moved lower
  • Dollar and foreign risk factors
    • Participants generally agreed that the drag on U.S. economic activity from the appreciation of the dollar since the summer of 2014 and the slowdown in foreign growth was likely to continue to depress U.S. net export for some time
    • Participants cited a number of lingering concerns
      • Further dollar appreciation
      • Persistent weakness in commodity prices
      • China could find it difficult to navigate the cyclical and structural changes under way in its economy
    • Many participants expressed the view that the risks to the global economy that emerged late this summer had receded and anticipated moderate improvement in economic growth abroad in the coming year as currency and commodity markets stabilized
  • Labor market conditions
    • Participants generally agreed that labor market conditions improved further in recent months
    • Most participants expected that the unemployment rate would edge below their estimates of NAIRU in the coming year
    • Many participants judged that the improvement in labor market conditions had been substantial
    • Some participants indicated that further progress in reducing labor market slack would be required before conditions would be consistent with the Committee’s objective of maximum employment
    • Some participants judged that a moderate further decline in unemployment would be unlikely to lead to a buildup of unduly strong inflation pressures
    • A few participants commented that a sustained period of labor market activity above levels consistent with maximum employment should speed the rise in inflation to the Committee’s objective
  • Financial conditions
    • Financial conditions tightened modestly over the inter-meeting period, with market prices suggested that investors were quite confident that the Committee would raise the federal funds target range 25 basis points at the current meeting
    • Concerns among investors about the High Yield bond market increased notably in the days before the meeting after an open-ended mutual fund specializing in junk bonds suspended redemption and closed
    • Several participants commented that markets for leveraged finance had been correcting since midyear – particularly for the most risky assets, including those associated with energy firms – and noted widening of credit spreads in corporate bond markets appeared to be largely due to repricing of risky assets
  • Consumer spending
    • Participants expected consumer outlays to be supported by ongoing gains in jobs, rising income, and improved household finances
    • Several participants pointed out that low energy costs should help support consumer expenditures
    • A couple Districts reported that households were spending cautiously and that some price discounting was likely
  • Business conditions
    • Business activity was solid outside of sectors adversely affected by low energy prices and weak exports
    • A number of participants commented on the strength in the services sector in their Districts (high-tech, transportation, leisure and hospitality, plus health-related businesses)
    • Some participants reported that the stronger manufacturing industries in their Districts include aerospace, power generation equipment, and medical equipment, plus the on-going strength in the domestic auto industry
    • Manufacturing activities overall continued to be restrained by weakness in industries with significant international exposures
    • High levels of domestic crop production and weak global demand had depressed commodity prices, and farm income was expected to decline
  • Housing market
    • Single-family home building continuing to trend up and multifamily construction remaining at a high level
    • Several participants noted factors pointing to continued improvement in the housing sector, including ongoing house price appreciation, low levels of home inventories, and the substantial gap between the rate of household formation and the relatively slow pace of construction
  • Fiscal developments
    • Federal spending was expected to provide a modest boost to economic activity over the next few years

Next article01 06 2016 | by Victor Xing | Economics

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